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Blockchain technology is currently being developed as a way to fundamentally transform our systems for, e.g., authenticating securities transactions and tracking securities ownership. In this article we review the possible impact of blockchain technology on retirement plan administration.
We generally use the term “blockchain” to describe what might more accurately be described as “distributed ledger technology.” In its paper on the topic, the Federal Reserve describes distributed ledger technology broadly as “some combination of components, including peer-to-peer networking, distributed data storage, and cryptography that, among other things, can potentially change the way in which the storage, recordkeeping, and transfer of a digital asset is done.” (Federal Reserve Board, Washington, D.C., Finance and Economics Discussion Series, Distributed ledger technology in payments, clearing, and settlement, Mills, Wang, Malone, Ravi, Marquardt, Chen, Badev, Brezinski, Fahy, Liao, Kargenian, Ellithorpe, Ng, and Baird. 2016-095.)
As implemented, distributed ledger/blockchain arrangements may range from the incremental – the adoption of “a few of the key components of [distributed ledger technology] as an enhancement to … existing technical platforms” – to the transformational – “replac[ing] entire functions traditionally managed by existing financial intermediaries … in very extreme but unlikely scenarios, the use of banks to conduct payments could become obsolete.”
The hallmark characteristics of a distributed ledger/blockchain system are: “reconciliation through cryptography, replicated to many institutions, granular access control, and granular transparency and privacy.” (UK Government Chief Scientific Adviser, Distributed Ledger Technology: beyond block chain, 2016.) Unlike current recordkeeping/custody systems, in which a “golden ledger” is kept by a central authority (e.g., a trustee/custodian or a plan recordkeeper), in a distributed ledger system the ledger is distributed to all participants in the network. In effect, participants in the network can see and use whatever level of data, including their own, to which their “key” grants them access.
Blockchain gained exposure with the development of Bitcoin. Bitcoin uses an unpermissioned ledger (that is, the ledger is open to everyone and cannot be owned), and participants in it are anonymous (or at least pseudonymous).
Implementations under consideration in the financial services industry generally involve permissioned ledgers, in which, for instance: “[S]ome participants may only be permitted to … send and receive asset transfers for existing assets. Other participants may have the ability to issue new assets. Still others may have permissions to validate transactions …, while another set of participants may be able to update the history of transactions to the ledger …. Some participants may be limited to only reading the ledger, while others may also be allowed to write to the ledger.” (Fed 2016.)
This structure may allow adaptation to current (legacy) processes under which, e.g., a selected person or group of persons has authority to validate information or transactions. Moreover, for a variety of reasons (very much including compliance with Know your Customer and anti-money laundering rules), financial services distributed ledger/blockchain implementations may not be anonymous.
There is great potential for distributed ledger technology within the securities transaction environment. With this technology, securities transactions would be proposed, executed and settled primarily via the distributed ledger: that is, “reconciliation through cryptography.” Information about the transaction would then be distributed to the ledger: that is, “replicated to many institutions.” The distributed ledger would hold all the information about this (and all other) transactions, providing “granular access control and granular transparency.”
Confidentiality would be implemented via cryptography – only those with permission would be able to decode ledger data (or specific elements of ledger data). But it is important to remember that all the data is still there in the distributed ledger. Whether a particular participant (or regulator or competitor) is able to see it would be determined/implemented through cryptography and permissions (“keys”).
Most agree that the likely path to this ideal (if there is one) begins with incremental improvements in current processes.
Much of the change this new technology will make in, e.g., custody and 401(k) recordkeeping will be driven by the deployment of blockchain in securities transactions (broadly defined). Because retirement savings assets make up a large percentage of the securities market, however, plans are likely to have significant impact on this process. One “cluster” of retirement plan issues may, however, see the development of blockchain solutions sooner rather than later: lost participants, small balances, moving money at job change, and the rollover process.
Considered broadly, blockchain presents two pairs of opportunities/risks:
The reduction of friction in securities and retirement plan transactions and simplification of the recordkeeping process will (dramatically) reduce the costs of most transactions.
But: Many of our current tools in 401(k) plans – e.g., automatic enrollment and default investments – depend on friction for their effectiveness. As friction is reduced, we will have to find new ways to “nudge” participants to the choices that (in most cases) are best for them.
The increase in transparency will make many tools more powerful – e.g., DB portfolio analytics, targeted communications, performance review – and at low or no cost. Managed accounts may, perhaps combined with AI, replace target date funds as the preferred default.
But: Depending on how the system is implemented, this enhanced transparency may permit greater scrutiny by regulators and (more problematic) data driven plaintiffs lawyers’ fishing expeditions.
One critical element of the implementation of blockchain technology is the use of smart contracts – contracts the terms of which have been reduced to software code (rather than legal language), that, in effect, self-execute when agreed-upon conditions are met. Their use in plan documentation and administration is likely to dramatically reduce current legal and administration costs.
Much of the discussion of blockchain sounds “futuristic,” and the most common question sponsors ask is, when will all this happen? In that regard, three observations:
Amara’s law states that “We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.” Progress is, for some time, likely to be modest and incremental.
Changes in the 401(k) system are likely to be driven by changes in the securities markets. That is, e.g., the transformation of 401(k) recordkeeping will likely be a consequence of securities transaction settlement being “put on the blockchain.”
Blockchain is a disruptive technology. The major custody banks all have blockchain projects, but (generally) 401(k) recordkeepers are sticking with current systems. Change in 401(k) recordkeeping (as distinct from custody) may be driven by new entrants.
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As blockchain is deployed in financial services, plan sponsors and plan providers will be under increasing pressure to adapt to it, to take advantage of the opportunities and manage the challenges it presents.